Can options spikes be a coincidence?

Whenever there’s a surprise takeover bid at a significant premium to the (formerly) prevailing stock-market price, dozens of journalists and bloggers immediately pull up options-volume data. Much of the time, they discover a suspicious spike in options volume just before the deal was announced. The conclusion is obvious: insider trading!

So many thanks to Baruch for bringing a bit of context to bear on such exercises. His main points: is that options volumes are by their nature extremely lumpy. Just about any options contract, if you look at it, will have occasional extremely large spikes. As Baruch puts it, “the volume of a particular option resides in Extremistan”.

What’s more, the options markets are constantly awash in rumors, any one of which can easily cause on of these spikes. Baruch provides one example: last Friday, a rumor hit the market that Palm would be bought by Nokia. It wasn’t, but that didn’t stop 21,000 options being traded in one day on the $12.50 calls alone. That’s over five times the size of the option volume in 3Com before it was bought by HP.

And one other thing: if you did have inside information that 3Com was being bought by Nokia, you’d make more money simply buying the stock than you would buying the options. The only reason to buy the options is if you simply don’t have the cash to buy the stock.

None of which is to say that there wasn’t insider trading in 3Com, of course. It’s pretty hard to prove a negative. But statistically speaking, if you look at options volumes on every takeover bid which crosses the transom, eventually one of them is going to see this kind of spike, even if there’s no insider trading at all.